Description
I’m revisiting Quadramed, an investment recommendation made back in March 2004 by Lindsay790. At the time, Lindsay790 convincingly and thoughtfully evaluated all aspects of Quadramed, suggesting an investment at its than current price of $3.15/share. The basic premise of Lindsay790’s recommendation was that Quadramed had just begun turning around and was apt to realize significant gains going forward.
To recap Lindsay790’s thesis, Quadramed, a candidate for bankruptcy prior to Lindsay790’s assessment, had beaten the odds and averted a filing. Standing in a better financial position, Lindsay790 outlined 3 catalysts that would drive the Company’s value higher: Settlement with SEC, Amex/NASDAQ potential listing (had been delisted from NASDAQ due to non-compliance) and increased analyst coverage. With the exception of increased coverage, all catalysts played out as expected, however the stock price continued to lose ground over the course of 2004 and into 2005, reaching a low of $1.10.
It is my premise that Quadramed, a healthcare information technology company, is stronger today then it has ever been, but trades at a significant discount to intrinsic value due to the overhang of historically poor performance. The catalysts for the stock today are as follows:
• Change in industry perception due to the Company’s strengthened balance sheet (hospitals have an aversion to doing business with enterprise software companies if solvency is an issue due to the long term nature of the business relationship)
• Significant operating leverage which will have a multiplier effect on operating earnings should sales in the Company’s Affinity product line increase to levels seen historically.
• Candidate for acquisition, confirmed recently by an unsolicited offer from an unnamed party, which was subsequently turned down by the BOD (Board of Directors). I believe this helps to establish a floor for the stock price with the potential for a sizable move to the upside in the event of an acquisition.
Corporate Summary:
Quadramed, a healthcare IT company targeting the 100 to 150 bed community hospitals, provides best-in-class hospital information and medical record systems. Its two primary product lines are as follows:
• Affinity – Provides enterprise-wide hospital information systems for patient management and revenue cycle management including pharmacy, lab and radiology applications. Quadramed’s product line for patient management systems has repeatedly won the Klas top award in the community hospital segment for hospitals in the 200 bed and under category. The Company’s product line is installed in over 200 hospitals nation wide (apprx. 5000 hospitals in the U.S.) with its laboratory and radiology information systems installed in 40 locations throughout Australia, New Zealand, and the U.K.
• Quantim – Provides medical record systems targeted for coding, compliance, abstracting and chart management as well as document management and imaging capabilities. The Company’s product line is installed in 1200 hospitals, second only in size to 3M’s share of market.
Operations:
Quadramed generates revenues from several areas: Service, Maintenance, Installation, license and hardware. The two largest segments for revenue generation are licensing and maintenance. Both areas provide a base of recurring revenues which, through existing hospital contracts, provide a foundation for stable revenues that can be relied upon annually, as there is little turnover in Quadramed’s clientele base. As an example, Larry English, Quadramed’s CEO (just recently retired), highlighted in the 1st quarter 2005 conference call that the Company’s recurring revenue base stood at $78mm. So, assuming Quadramed can continue to sell its systems, recurring revenues should continue to grow, adding to its existing annuity base of business.
The key area for growth for the Company, as has been stated by its former CEO, is its Affinity product line. Although the Company has been able to generate modular sales (component sales) with this product line, the Company has struggled to increase its complete, enterprise-wide, system sales, which over the last several years has gone from 10 in 2001 to 3 in 2004. The decrease in units sold since 2001 was due, primarily, to the Company’s historical financial instability, which forces hospitals to reconsider partnering with an IT vendor on system wide implementations if their long term financial viability is in question. However, circumstances, I believe, have changed today creating an opportunity for growth in Quadramed’s Affinity enterprise product sales.
Quadramed’s story:
Founded in 1993, Quadramed’s strategy was to grow through acquisition, rolling up numerous healthcare IT companies with the goal of assisting healthcare providers to improve productivity, maintain regulatory and legal compliance and enhance the quality of patient care and safety. This strategy worked up until the late 1990’s when customers and investors lost confidence in the founding management’s ability to integrate the acquisitions or to develop a cohesive strategy for the Company. The stock price sank. Key management disserted the Company, lawsuits were filed and expenses ran amuck.
Larry English was brought in in June of 2000 to restructure the Company. He successfully cut costs, hired new management, sold off unprofitable and non-strategic assets, paid down debt and increased cash. In 2001, he successfully implemented a go forward strategy which the market responded favorably to resulting in a recovery of the stock price. Unfortunately, this was short-lived due to accounting issues that surfaced in the second quarter of 2002.
New auditors indicated that the Company’s revenue recognition policy was incorrect and that acquisitions made during the 1997 to 1999 period had been accounted for improperly. As a result, Quadramed was forced to restate its financials, which ultimately resulted in the Company being delisted from the NASDAQ. Due to the delisting, the Company was in technical default of its lone covenants forcing it to pay down its $70mm in loans outstanding. Fortunately, as a result of Larry English’s efforts, Quadramed was able to refinance its obligations and temporarily avert bankruptcy.
The restatement phase was completed in June of 2003. The adjustments required for compliance purposes had only to do with the Company’s revenue recognition problems and nothing to do with improper or fraudulent accounting of its acquisitions. Although these issues had been resolved, several more remained including an SEC investigation, shareholder lawsuit and questions in the marketplace regarding the solvency of the Company. In 2004, Quadramed resolved most of these outstanding issues by settling both the SEC investigation (non-cash settlement) and shareholder lawsuit (settlement mostly paid for by insurance). The Company also exchanged its long term debt for convertible preferred, further strengthening its balance sheet and dispelling any concerns over solvency issues. Moreover, the Company was able to secure a listing on the Amex helping to validate the Company’s continued improvement.
As this multiyear restructuring and recovery continued into 2004, the Company also focused its efforts on completing 2 acquisitions to help round out its product offerings in its scheduling and laboratory product lines. Both companies, Tempus and Détente, were acquired using Company stock and cash from the preferred offering, and helped to add another layer of revenues and product diversification to the Company’s suite of product applications.
Finally, the first 3 quarters of 2005 showed a continued trend of improved operating results with the exception of top line growth (sales are trending slightly lower for the full year due to 0 Affinity sales). In Q2, Quadramed generated $1.2mm in income from continuing operations and approximately $1mm in Q3, however Q3 results are on a proforma basis due to one time charges taken in the quarter. Putting Q3’s one time charges aside, both quarters show a dramatic improvement over past performance, which is indicative of a multi-year, restructuring strategy that is now beginning to show positive results.
Below I’ve put together a 4.75 year historical financial picture, which illustrates the evolution of the Company’s operating performance. The key areas to focus on are the SG&A % reduction from 2004 as compared to the first 9 months of 2005, the exchange of long term debt for convertible preferred in 2004, and the dramatic increase in free cash flow in the first tree quarters of 2005. Basically, management has been able to reduce SG&A by 8%, remove the threat of bankruptcy, and increase free cash flow from a deficit of ($14.8mm) to a surplus of $13.0mm (not including the deduction of the preferred dividend which amounts to approximately $5.5mm).
9 months 2005 2004 2003 2002 2001
Revenue 91,104 130,456 125,105 109,585 117,046
GM 63.2% 56.50% 61.60% 58.70% 63.40%
SG&A 34.41% 42.50% 47.50% 45.70% 49%
R&D 25.50% 21.50% 18.40% 16% 12.60%
Dep&Amor 4.16% 4% 4% 5.60% 7.7%
Restat.
expense - - - 7,461 7,463
Exit
cost of
facility 1066 4,190 - - -
Impairment
charges
for
Financial
services
division - 3,332 - - -
Gain/
loss
from
oper. -2.41% -17.40% -13% -17% -4.70%
Interest
expense/
income 763 (5,372) (9,439) (3,461) (4,741)
Gain/loss
on
redemption
of
debentures - (14,871) - - 12,907
Income
(loss)
from
continuing
oper. -2.94% -32.06% -19.14% -19.03% 10%
Gain (loss)
on disc.
Oper. (2,503) - - (2,280) (2,539)
Gain
on
disposal
of disc.
Oper. - - - 8,776 -
Net income
(loss) -6% -32% -19.1% 13.10% 8%
Preferred
stock
accretion (3,573) (2,465) - - -
Diluted
income
(loss)
per share (0.22) (1.23) (0.87) (0.53) 0.35
Specific
balance
sheet
items: 9 mon 2005 2004 2003 2002 2001
Cash
and
cash
equiv 33,992 22,426 36,944 26,191 32,213
Deferred
revenue 50,025 44,040 48,502 39,492 30,721
Long term
debt - - 84,225 73,719 73,719
CFO less
Capex 13.0mm (14.8mm) (2.4mm) (1.4mm) 11.1mm
(Sorry for all the financial information, but I find it useful when evaluating the operational trends of the business).
Current status:
As is evident from the above data, Quadramed is financially stable today. With $34mm in cash and $13.0mm of free cash flow (which should increase assuming profits and deferred revenues rise), the Company has very little balance sheet risk and all the financial stability required to grow its top line. Although the first three quarters of 2005 showed zero growth in the Company’s Affinity sales, Quardramed was granted a 5 year contract to be the national vendor for all VA hospitals. .
Also, in my discussions with management, and in statements made during the 2nd quarter conference call, it’s the Company’s expectation that Affinity system sales increase to between 6 and 8 units per year based on a study conducted by hired consultants evaluating the healthcare IT marketplace and the degree of penetration the Affinity product should have within that space. Should the forecast hold up, and sales of the product line double - or, ideally, more then double – operating profits should increase significantly due to the Company’s degree of operating leverage.
Acquisition offer:
Recently, Quadramed was approached by an unnamed party interested in purchasing the Company. The group made an undisclosed offer, which was assessed by a separate committee set up by the Company. Included in the evaluation were several of the Company’s largest shareholders. The committee’s final decision was not to pursue the sale of the Company, however, management did indicate in the 2nd quarter conference call that an acquisition offer would be accepted if it provided the most value for its shareholders. Apparently the offer made did not meet the appropriate value level for engagement, but it is interesting to note that the offer was seriously considered and evaluated, and by virtue of the process can be construed as meaningful. This, in my opinion, helps to establish a floor for the stock price with the potential for significant upside should there be other acquisition offers.
Relative value:
Not surprisingly, Quadramed’s value is significantly discounted to that of its peer group, which also could have prompted the unsolicited offer. I’ve provided a table below comparing Quadramed’s value to that of its competitors.
QD CERN CPSI
Market Cap: 57.36M 3.50B 437.0M
Employees: 755 5,345 763
Qtrly Rev Growth (yoy): -2.40% 12.60% 28.50%
Revenue (ttm): 125 1.08B 104.4M
Gross Margin (ttm): 74.00% 78.00% 44.00%(a)
EBITDA(b) (ttm): 14.0M 257.7M 33.1M
P/E (ttm): N/A 43.8 33.6
TEV/Sales 0.88 3.14 4.01
SFCF(c)(ttm) 4.5M 47.5M 12.5M
(a)CPSI use completed contract method of accounting where QD and CERN use a combination of both completed contract and % of completion accounting methods.
(b)Excludes all one time charges and preferred stock accretion expenses
(c)SFCF(structural free cash flow) = NI + Depr and Amort - Capex - Pref Dividend I've used this calculation to normalize differences between the listed companies.
The one statistic that specifically jumps out is the TEV/Sales ratio (total enterprise value to sales ratio). It’s evident from this one metric that Quadramed is valued at a significant discount to its competitors. I realize that the discount at which the Company trades is not without merit considering its overall lackluster historical performance, but that’s also why I believe an investment opportunity exists. If the Company can begin to realize top line growth and improve operating margins – which should happen as sales increase based on the Company’s operating leverage – Quadramed’s discount should quickly disappear.
Industry:
As stated in Cerner’s 3rd quarter filing:
“The third quarter of 2005 continued a trend of positive developments in the healthcare information technology marketplace. A significant development during the quarter was the publication of RAND’s peer-reviewed study that indicates healthcare information technology could save the country’s healthcare system $162 billion annually through improved efficiency, disease management and reduced adverse drug events. This study provides large-scale, independent, quantified proof of the impact healthcare information technology can have. The potential savings indicated by this study represent nearly 10 percent of the $1.7 trillion the United States spends annually on healthcare. These findings should be of particular interest to the federal government, which incurs significant healthcare costs through Medicare and Medicaid funding”.
“There have now been more than 20 healthcare information technology bills introduced with broad bipartisan representation. The results of the RAND study should help support these bills as it provides evidence of a return on investment in healthcare information technology. These bills propose facilitating healthcare information technology investments by offering incentives such as direct grants, favorable tax treatment, amended Stark and anti-kickback rules, healthcare information technology loans, and differential reimbursement. With respect to the Stark rules, Health and Human Services (HHS) Secretary Mike Leavitt announced two proposed rules in October that could create exemptions from the Stark laws that would allow hospitals to furnish or donate hardware, software, and related training services to physicians for e-prescribing and electronic health records”.
“Another positive development is that Moody’s Investors Services recently reported that year-to-date rating upgrades for not-for-profit hospitals are equal to downgrades, which is a better ratio of upgrades to downgrades than all but three of the past 17 years. This positive view was echoed by Standard & Poors in October when they reported more upgrades than downgrades this year and a strong financial outlook due to favorable volume trends, rate increases, and cost containment”.
We’ll have to wait and see if any of the above materializes, but should the Government begin subsidizing health information technology for not-for-profit hospitals,all companies within the industry would benefit. Quadramed in particular would benefit enormously considering their core market is the mid to small size not-for-profit hospitals.
Caveats:
First, a management change has occurred at Quardramed. Larry English, the former CEO, has just recently stepped down after 5 years of very effective leadership. His replacement is Keith Hagen, an outside executive personally chosen by Mr. English. Interestingly, Mr. Hagen was the Chief Technology Officer of Compucare, a company Quadramed acquired in 1999, where he was responsible for the development of the Affinity platform. Following Quadramed’s acquisition of Compucare, Mr. Hagen left to pursue other opportunities. He has now returned and his intimate knowledge of Quadramed’s Affinity software solution should be of great assistance in its continued development. As for his abilities as a manager and operator, only time will tell if his appointment will blaze a new path to prosperity for the Company.
Second, although muted in the event of improved operating performance, is the overhang from large amounts of convertible preferred stock, options and warrants. Should all common stock equivalents be converted, and assuming no share buybacks, the number of shares outstanding will double. Now, the exercise price for the conversion of most of these securities ranges between $3.10 and $3.40, establishing a hurdle price that may be difficult to surpass.
Third, in the 4th quarter of 2004, Quadramed began converting its financial records over to its Peoplesoft enterprise system, resulting in control deficiencies in accounting for its revenue and closing cycles. That said, management continues to be vigilant about completing its financial conversion and implementing the required controls to eliminate any errors that might arise from their control deficiencies. To date, only nominal accounting errors have been detected, which have since been corrected.
Finally, if Quadramed is unable to show top line growth and the Company continues to languish within its current state, the stock price may continue to recede due to stock holder frustration and/or fatigue. Or, if sales slow and revenues begin to fall, a mass shareholder exodus might occur, significantly impacting the stock price.
Conclusion:
It is my basic premise that an investment in Quadramed constitutes, by all measurers, a safe one based on its risk return profile. On the downside, the probability of bankruptcy is highly unlikely based on the strength of the Company’s balance sheet and recurring revenue base. At worst, revenues could begin to falter, causing some degree of corporate downsizing, however, I suspect the Company would be sold well before any significant reductions in revenues occurred, helping to cap any downside loss. On the upside, if Quadramed can re-ignite its Affinity, enterprise system sales to the levels suggested by its consultants, the stock has the potential of doubling or tripling in the very near term.
Catalyst
It is my premise that Quadramed, a healthcare information technology company, is stronger today then it has ever been, but trades at a significant discount to intrinsic value due to the overhang of historically poor performance. The catalysts for the stock today are as follows:
• Change in industry perception due to the Company’s strengthened balance sheet (hospitals have an aversion to doing business with enterprise software companies if solvency is an issue due to the long term nature of the business relationship)
• Significant operating leverage which will have a multiplier effect on operating earnings should sales in the Company’s Affinity product line increase to levels seen historically.
• Candidate for acquisition, confirmed recently by an unsolicited offer from an unnamed party, which was subsequently turned down by the BOD (Board of Directors). I believe this helps to establish a floor for the stock price with the potential for a sizable move to the upside in the event of an acquisition